The oil and gas industry has been going through various upheavals. The last 12 months especially have been pretty eventful, with fluctuating supply (or maybe just fears of fluctuating supply) and steadily increasing demand causing marked unpredictability in crude oil prices. In particular, the refining industry has been bearing the brunt of the volatile markets. However, that's exactly where I see a huge opportunity waiting to be exploited. Let me explain how.
The first thing that needs to be understood is that the different crude oil benchmark prices have not been the same at any time. The two most popular benchmarks -- the West Texas intermediate, or WTI, and the Brent crude -- have been trading with a significant difference in prices. Brent crude has been trading at a premium compared to the WTI variant in 2011. The resulting difference between the prices of each of these blends (called the Brent-WTI spread) has been significant enough to impact refining margins.
Here's how the spread looked in the past six months:
Source: Energy Information Administration.
We see that WTI crude has been trading at a significant discount compared to Brent. From late August to mid-October, the spread was a solid $25 or more per barrel. More or less, those refiners processing the WTI had access to cheaper raw material. And hence, they are the cash kings.
However, the amazing part is this: The stock markets never recognized this in the past six months. In fact, Mr. Market has been largely driven by sentiments such as the Seaway pipeline reversal, the Keystone XL pipeline delay, and non-utilization of full capacity in some refineries. Sound fundamentals have never been entirely the basis of stock movements in the past few months.
So which of these refiners process WTI crude? They are the ones with refineries in the mid-continental belt. The following table shows how the market underestimated these stocks:
Stock Returns in the Last 6 Months
Average P/E in the Last 24 Months
Sources: Yahoo! Finance and S&P Capital IQ.
The numbers tell us one thing. Refining stocks are oversold. But out of these, I'm particularly interested in those companies whose major refineries are located in the mid-continental belt of Texas, Louisiana, and Oklahoma.
Stock No. 1: Western Refining
Overall refinery gross margin shot up by an astounding 137% from 2010. Though fundamentals weren't too impressive in 2011, things should look much better in the coming year. The company's biggest refineries -- the El Paso and Gallup refineries -- should pick up refining production once again.
And yes, the stock is cheap. Current P/E has fallen drastically, including the returns in the past six months. Additionally, January has once again seen the Brent-WTI spread rise following rebalancing of annual contracts, as well as investors fearing a shortage in Brent supply.
Stock No. 2: HollyFrontier
Though it's not a strict mid-continent operator, HollyFrontier's trailing P/E is way below its average P/E. This stock is dirt cheap. Its 85,000-barrels-per-day Tulsa refinery, acquired in 2009, has been producing results right away. But the market doesn't seem to have noticed. Holly's merger with Frontier Oil has ensured access to the 135,000 bpd refinery located in El Dorado, Kan. -- again a move that hasn't been noticed.
Stock No. 3: Marathon Petroleum
The spinoff from Marathon Oil says it all. The company has already been taking advantage of the WTI-Louisiana spread. Marathon's forte lies in the fact that all of its six refineries are in the Gulf Coast and Midwest regions. That, I believe, is good enough. Improving fundamentals are only a matter of time for the newly formed spinoff. And it's cheap.
I'm not too bullish on Valero simply because most of its refineries are located on the East Coast, which has a much higher exposure to the Brent variant. Hence, despite its stock having fallen considerably, the underlying fundamentals with regard to pricing aren't too impressive.
I believe these three refining stocks are the ones to look out for this year. But if you're looking for more ideas, The Motley Fool has created a special oil report titled "3 Stocks for $100 Oil," which you can download today, absolutely free. In this report, Fool analysts cover three outstanding oil companies. To get instant access to the names of the three oil stocks, click here -- it's free.
Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool owns shares of Western Refining. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.